Bullard is saying that the Fed will have to do some of the policy normalization by shrinking its balance sheet if it is to avoid the spectre of a flat curve. And I think this is the view that will come to the fore at the Fed. This means the Fed’s rate hike train will be less severe than the Fed has laid out. Invest accordingly

That’s how I ended my Fed piece in mid-February. St Louis Fed President Bullard was already talking about the Fed’s balance sheet in February. And with the release of the Fed minutes from March, we now see this is where things are heading. Let me make a few comments about the Fed minutes below and what they tell us about where the Fed is going.

The primary question on investors’ minds has been how many rate hikes are we going to see. Fed officials have been talking up rate hikes, with some going as far as to suggest more hikes than the three forecast at the last FOMC meeting. But there’s a lot of uncertainty around that outcome since the Fed has said it is data dependent. Good data means more hikes, worse data means fewer. And markets know this because they are shading toward fewer hikes – with the probabilities at 10.5% for none, 35.4% at one more, 37.1 at two more and only 16.9% for more than three hikes total this year, including the one from March.

But what about running down the balance sheet — reverse QE if you will? I think this is where the Fed minutes offered some new thinking.

Let’s remember the Fed’s preference for rate changes over quantitative easing or forward guidance alone as the Fed eased. In reversing course, the Fed has reversed the order though and moved straight to hikes instead of paring back its balance sheet. And the impact has been to increase risk by flattening the yield curve. Two more hikes and the yield curve could be as flat as a pancake. So now the question is: when and how should the Fed reverse its QE program and shrink its balance sheet?

Consistent with the Policy Normalization Principles and Plans, nearly all participants preferred that the timing of a change in reinvestment policy depend on an assessment of economic and financial conditions. Several participants indicated that the timing should be based on a quantitative threshold or trigger tied to the target range for the federal funds rate. Some other participants expressed the view that the timing should depend on a qualitative judgment about economic and financial conditions…

When the time comes to implement a change to reinvestment policy, participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS…

Nearly all participants agreed that the Committee’s intentions regarding reinvestment policy should be communicated to the public well in advance of an actual change. It was noted that the Committee would continue its deliberations on reinvestment policy during upcoming meetings and would release additional information as it becomes available.

Why this matters: As the economic data come in, we now see the Fed has two choices for imparting policy tightening: rates and balance sheet actions. The Fed has now told us it has discussed how to implement the balance sheet shrinkage and how it will communicate its readiness to do so. And since the Fed told us explicitly that buying assets and growing its balance sheet was an additional signal of easing, we should take balance sheet shrinkage as an additional form of tightening.

In effect, the Fed is saying to us that the order — whether easing or tightening — is always rates first, balance sheet second, and that when it moves to its balance sheet, this should always be taken as an additional and more forceful policy signal.

Given the bullish economic outlook expressed in the FOMC statement, I see these minutes as hawkish. They are a sign that the Fed believes the economy is ready for it to move aggressively. In due course, we will see further tightening in the form of rate hikes and balance sheet shrinkage occurring at the same time.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.